What is income tax?
Taxes levied on the earnings of companies and individuals are referred to as income taxes. Earnings subject to income taxes can come from diverse sources, including wages, salaries, dividends, interest, royalties, rents, gambling winnings, and product sales. In the United States, income tax is one of the biggest sources of revenue for the federal government.
When people talk about income taxes, they generally mean individual income taxes, paid by employees or other people who earn income. However, companies, estates, trusts, and many other types of entities also pay income taxes based on revenue or income.
- Individual income tax: Most people do not pay tax on all of their earnings. Instead, the Internal Service Revenue (IRS) offers a series of deductions, based on mortgage interest, a percentage of medical and dental bills, education expenditures, and many other expenditures. People subtract these deductions from their gross income to determine their taxable income.
- Business income tax: Businesses — small businesses, self-employed contractors, partnerships, and corporations — are required to pay income tax based on their revenue. These entities report their business revenue and then deduct capital and operating expenses. The difference is their taxable income.
- State and local income tax: Most states in the U.S. charge income tax. As of 2017, only seven states don’t require people to pay income tax: Wyoming, Washington, Texas, South Dakota, Nevada, Florida, and Alaska. Tennessee and New Hampshire only collect income tax on investments and dividends.
The U.S. income tax system is a voluntary system. Not in the sense that paying income tax is optional, but rather the federal government depends on each taxpayer to voluntarily report all of their earnings on a tax return and compute the appropriate tax themselves.
The IRS enforces tax laws and ensures that everybody pays tax properly. The agency gets a copy of a person’s W-2 form each year, and if she does not file a return, the agency can easily calculate her tax and send her the bill. The IRS can also charge interest and penalties to people who pay tax late, and file lawsuits against tax evaders.
Need help with tax planning? Check out Bankrate’s tax calculators.
Income tax example
Fernando earns $150,000 a year in salary, and this year he earned $18,500 in short-term capital gains and $3,000 from long-term capital gains. This puts his total income at $171,500. Under IRS rules, he may deduct his state and local taxes of $12,000 and charitable contributions of $2,000 from this amount, plus four personal exemptions of $4,050 each for himself, his spouse and his two children. This puts his total taxable income at $141,300. His total income tax would amount to $26,000.